A modest proposal for monetary policy

The Bank of Canada’s policy of “inflation targeting,” which seeks to keep the rate of inflation between 1 and 3 per cent, has the support of an overwhelming majority of Canadian academic and business economists. The monetary instrument to deploy when the inflation rate is outside of this desired range is short-term interest rates – raise them when inflation is above the target range and lower them when below. A key if unstated corollary is that the value of the loonie is to be allowed to float freely – the exchange rate is ignored in calibrating monetary policy.

In contrast, Robert Mundell, Canadian Nobel laureate in economic sciences, argued that the exchange rate is the most important price in the Canadian economy. Following upon Mundell, the thesis in what follows is that ignoring the international value of the loonie in the framing of Canadian monetary policy, and in particular ignoring the loonie’s dramatic swings vis-à-vis the U.S. dollar over the last two decades, is questionable if not foolhardy. While there are times when a depreciation of the loonie is to be welcomed on economic grounds, Canada’s experience has too often involved dramatic overshooting of the currency, both upward and downward, which is unhelpful in both the short and the longer term.

The underlying issue is straightforward: the Canadian currency area is too small and too open for a freely floating exchange rate to accommodate both a world-class manufacturing sector and a global energy superpower. As figure 1 reveals, Canada’s exchange rate appreciated and depreciated more or less in lockstep with increases and decreases in global crude oil prices between 1994 and 2013. Readers will recognize this as the proverbial Dutch Disease – the global demand for energy drives up Canadian energy prices and export volumes, which in turn serves to appreciate the loonie and devastate the export potential of the Canadian manufacturing sector.

This is particularly problematic in the Canadian federal context since manufacturing and resources are located in different regions/provinces. Intriguingly, while the appreciation clearly damages manufacturing-intensive Ontario, it may create challenges for energy-intensive Alberta as well. Since global energy prices are set in U.S. dollars, if the percentage appreciation of the loonie equals the percentage rise in energy prices then the Canadian dollar value of a barrel of exported oil is unchanged. Phrased differently, an energy price–driven exchange rate serves to stabilize the energy sector, but it destabilizes the manufacturing sector. This approach is more than a bit strange in terms of stabilization policy principles – a freely floating exchange rate protects the immobile factor (oil in the ground) but enables, if not encourages, the migration of highly mobile factors (corporate capital)! To be sure, and in offsetting fashion, Canadian consumers will gain from an appreciating loonie to the extent that they purchase imported products or import-intensive products of Canadian manufacturers.

To appreciate the economic damage that can arise in the wake of excessive exchange-rate volatility, it is instructive to review Canada’s experience over the last two decades, and in particular since the millennium. Toward this end, figure 2 presents three indices (with 2002 = 100). The bottom line in the post-2002 portion of the figure represents United States unit labour costs (ULCs) in U.S. dollars; the middle line post-2002 represents Canadian ULCs in Canadian dollars; and the uppermost line post-2002 represents Canadian ULCs expressed in U.S. dollars. Circa 2002, the Canadian economy was expanding rapidly, thanks to the U.S. high-tech boom and to our dramatically depreciated exchange rate (one Canadian dollar cost about 63 U.S. cents). In turn, the low value of the dollar reflected the collapsed price of oil – under $30 per barrel as indicated in figure 1.

This was the lay of the land, as it were, when Richard Harris and I penned our 1999 C.D. Howe Institute Commentary From Fixing to Monetary Union.1 We argued that the exchange rate should not have been allowed to depreciate this far and that it would likely have deleterious implications for future manufacturing growth and productivity. Specifically, the low-60-cent Canadian dollar set the stage for two very problematic economic developments.

The first of these was that Canada’s capital-labour ratios (for both physical and human capital) would likely decline from what otherwise would have been the case and, therefore, so would Canadian productivity growth. There were two facets to this first argument. One relates to the traditional capital-labour ratio. Since machinery and equipment are typically priced in U.S. dollars, the low-60-cent range for the exchange rate meant that these investments were extremely expensive in Canadian dollars. As a result of these exchange-rate induced decreases in our capital-labour ratios, we predicted that Canada’s productivity growth and, therefore, our competitiveness would fall short of what it could have been.

The second facet relates to the then-ongoing “brain drain” – the low exchange rate combined with American demand for skilled labour triggered the emigration of Canadian talent to the United States in search of higher – typically dramatically higher – wages. This led to a lower ratio of human capital to labour (or of skilled labour to unskilled labour) than would otherwise have been the case. As a result of the likelihood of these exchange-rate decreases in our capital-labour ratios, we predicted that Canada’s productivity growth and, therefore, our competitiveness would fall short of what it could have been.

Our second overarching concern was that the exchange rate was so far below purchasing power parity (typically deemed to be in the 85–90 cent range) that some significant rebound in the exchange rate was inevitable. This would exacerbate the competitive challenge alluded to in the previous paragraph both in its own right and because the then-existing high demand for labour in Canada was increasing wage rates, the negative competitive impact of which would also be heightened by an appreciating loonie.

In the event the appreciation was unexpectedly fast and furious. This was in large part due to the Canadian version of the Dutch Disease – the very close correlation between the price of crude oil and the appreciation of the loonie illustrated in figure 1 (a correlation of 0.94 between the first quarter of 1994 and the third quarter of 2013). Arguably, however, there are also factors other than oil prices that heighten exchange-rate volatility and overshooting. Important among these other factors was and is the role of financial speculation. If the loonie is appreciating, then foreigners investing in short-term Canadian paper will be rewarded with returns above the stated interest rate, and these returns will, in turn, invite more investment in Canadian paper and trigger further appreciation, and so on. The opposite scenario is at play when the loonie is depreciating. Hence, the anticipation of exchange-rate gains or losses on the part of financial speculators is part of the overshooting phenomenon because our monetary authorities are willing to allow the loonie to move whenever and wherever international markets dictate.

With this as backdrop, let us now focus in more detail on figure 2. From 2002 to 2011 the increase in Canada’s unit costs, expressed in Canadian dollars, was 13 per cent. In sharp contrast, U.S. unit labour costs declined over the 2002–11 period by 14 per cent. While many factors are probably at play in this overall 27 per cent decrease in own-currency ULCs in the United States relative to Canada, some of this reflects our prediction of a deteriorating Canadian ULC for reasons elaborated above.

However, the startling message from figure 2 is that that Canadian unit labour costs expressed in U.S. dollars have increased by 80 per cent since 2002: this is the top line in the figure, which takes account of both the increase in Canadian-dollar ULCs and the appreciation of the loonie. But even this is not the end of the story since, as already noted, U.S. ULCs have fallen by 14 per cent. Overall, therefore, the increase in the ratio of Canadian unit labour costs in U.S. dollars to U.S. unit labour costs was not far off 100 per cent over the 2002–11decade.

The bottom line here is astounding: after a half-dozen or so years of similar patterns in Canadian and American unit labour costs prior to 2002, Canada’s ULCs in U.S. dollars relative to U.S. ULCs increased between 2002 and 2011 to a degree that significantly compromised Canada’s manufacturing competitiveness. To be sure, the degree of export impairment rises with the proportion of Canadian value added. Nonetheless, the possibility that these largely exchange-rate driven ULC differentials were a key factor in the series of closures and/or transfers of Ontario plants to the United States – Caterpillar, Kellogg’s, Heinz, CCL aerosol and the Fergus water heater plant, among others – cannot be ruled out.

However, focusing on enterprises that have been repatriated to the United States is not the whole story of the problems created by exchange-rate hypervolatility. Canada’s oft-cited trumps as a manufacturing location for NAFTA economic space – medicare, safe neighbourhoods, good public schools, a highly qualified labour force, a continental-European social envelope, and even our lower corporate tax rates relative to the United States – suggest that we should have a much larger share of NAFTA’s inward foreign investment than we currently do. My hypothesis as to why we don’t is that prospective foreign investors are scared off by the risk associated with the hypervolatility of the loonie. Why would they locate in Canada and put 90 per cent of their output (i.e., that destined for the U.S. market) in the hands of our monetary authorities? Much better to locate in the United States and allow our monetary authorities to determine the direction of the remaining 10 per cent of their production.

Thankfully, the exchange rate has come down from its recent highs and is, at time of writing in March 2014, hovering around 90 cents. Perhaps another cent or two decline is acceptable on purchasing-power-parity criteria. The Bank of Canada should not allow the earlier scenario to be repeated. Canada needs to provide economic/export stability to potential foreign investors and to our existing corporations – 60 per cent swings up and down in the value of our currency with respect to that of our largest trading partner are completely unacceptable and obviously detrimental to the future of Canadian manufacturing. However, this view runs counter to that of the Bank and of the influential academic and Bay Street macro-policy community. One should remind them that even the fabled Swiss franc is now subject to central bank intervention if it is tending to appreciate beyond some predetermined level relative to the euro. I recognize that carrying this volatility argument to its limit would lead to a fixed-exchange-rate regime – pegging the loonie to the greenback. Indeed, I am on the record as having argued in an earlier article for a common currency with the Americans. While the case for a common Canada-U.S. currency area will be enhanced if and when the United States becomes the preeminent market for Canadian energy exports, one need not go that far.

Setting a common currency aside, Canada needs to rethink monetary and macro policy in ways that will allow both energy and manufacturing to flourish in the upper half of North America. There are two polar approaches that suggest themselves: (1) alter the calibration of Canadian monetary policy and (2) alter the relationship between energy prices and the exchange rate as expressed in figure 1. There is also a third approach that would be a combination of the above two. These will be dealt with in turn.

Rethinking monetary policy targets and instruments

The Bank’s choice of monetary policy targets and instruments has evolved quite dramatically over the past half century. The prevailing paradigm in the early 1970s was the “credit conditions” approach. The fuzzy nature of this approach is best exemplified by a fascinating exchange in a U.S. congressional hearing where the Federal Reserve representative stated that the existing U.S. credit conditions were “easy, but not that easy.” In the ensuing question period he agreed that the existing credit conditions could also be described as “tight, but not that tight”! Thankfully, under Governor Louis Rasminsky, and with monetarism gaining influence in the academy, the Bank of Canada at the time adopted monetary targeting as its operational goal. However, monetary targeting eventually had to be abandoned because the demand function for the chosen monetary aggregate (M1) proved to be empirically unstable.

After a period of nominal income targeting, the Bank opted for inflation targeting, and this remains the ongoing monetary policy paradigm. At one level this has been a tremendous success both in Canada and elsewhere – a record number of countries now have low inflation rates. While not denying the role played by inflation targeting, the reality of a billion and a half new workers from China and other emerging markets entering the global labour force and of China effectively becoming the workshop of the world while pegging its yuan to the greenback ensured that inflation would be tamed virtually everywhere. Indeed, concern over disinflation has recently loomed larger than that over inflation.

All this by way of making the point that the destabilizing pressure on our economy is now much more likely to come from variations in the international price of the loonie than from the domestic price of the bundle of goods and services that constitute the consumer price index (CPI), especially since many of the CPI components are traded globally. Moreover, as the global economy as well as energy prices rebound, Canada’s role as an energy superpower will again kick in and have the potential to replicate the patterns exhibited in figures 1 and 2, replete with dramatic interregional implications. A policy to maintain prices within the 1 to 3 per cent inflation target under this scenario will be a Pyrrhic victory, especially on the export and interprovincial front.

Within this overall macro framework (to be elaborated further in the following section) a preferable monetary policy strategy would be to pursue the 1–3 per cent inflation targeting within an agreed range for the loonie, for example several cents on either side of the purchasing-power-parity (PPP) value for our currency. This would be a variant of the earlier-noted policy of the Swiss National Bank to pursue monetary policy so that the value of the Swiss franc relative to the euro does not rise above approximately €0.85. The proposal for Canada would differ from that in Switzerland: it would include a provision limiting both the appreciation and the depreciation of the Canadian dollar. Moreover, the Bank of Canada holds large foreign exchange reserves that, if need be, it could draw on to facilitate this inflation-cum-exchange-rate target, moving its reserves in and out of international markets to assist in achieving the dual target.

Having thus proposed an alternative monetary framework designed to temper exchange-rate volatility, I would now like to focus on a more direct approach: to break the link between energy prices/exports and exchange rates.

Resource stewardship and exchange rates

It is instructive to come at the relationship between energy prices and the exchange rate expressed in figure 1 from the perspective of the resource stewardship dimension. Former federal cabinet minister David Emerson argues that Canada’s governments have an implied custodial and stewardship responsibility to manage resources across the generations. His perspective on the relationship between stewardship and resource revenues merits quotation:

In fiscal and economic terms, non-renewable energy and natural resources are long life, fixed assets that, when sold and monetized, should be invested in ways that will benefit Canadians over the longer term. Pretending that resource revenue is just another form of operating revenue, to be spent on current consumption of public services, is an abrogation of this responsibility.2

Elsewhere Emerson has written, “We have pretended the income statement and the balance sheet are basically interchangeable. We sell assets and call the proceeds income.”3

In the economics literature, the optimal approach to this issue is referred to as the Hartwick Rule (named after my Queen’s economics colleague John Hartwick). The essence of this rule is that the proceeds of the sale of nonrenewable natural resources should be placed in a provincial sovereign wealth fund (PSWF) and only the annual return on the PSWF should be brought into the current budget. This would allow both current and future generations (of Albertans, for example) to share in the benefits from harvesting the province’s nonrenewable resource assets. Readers will recognize that this is along the lines of the Norwegian sovereign wealth fund approach to its North Sea energy revenues. The additional key feature is that the Norwegian SWF is invested in international markets. Were the energy-rich provinces to follow suit and invest their PSWFs in international markets, this would break the tight relationship between energy prices and the exchange rate. Revenues from energy exports would, in a neutralizing fashion, be redeposited in international markets. As noted, the annual return on the PSWF would be drawn into a province’s current budget.

Thanks to section 92A of the Constitution Act, 1982, the provinces have exclusive access to energy rents and royalties, so the decision to mount provincial sovereign wealth funds rests with the provinces, not with Ottawa. However, Ottawa would be wise to encourage the creation of PSWFs on stewardship as well as on macroeconomic grounds, while at the same time urging the provinces to view PSWFs as a quid pro quo for the right and privilege of having exclusive access to nonrenewable resource revenues – a right that to my knowledge exists in no other federation.

Were the provinces to embrace resource stewardship, the role for monetary policy in keeping its eye on the exchange rate would be lessened considerably: the energy-rich provinces would play a key role in limiting exchange rate gyrations. Indeed, the combination of resource stewardship via PSWFs on the one hand and adding an exchange rate dimension to monetary targeting (if and when the stewardship/PSWF approach falls short) will allow Canada to become at the same time a global energy superpower and a world-class manufacturing location.

Neither of these proposals would be original to Canada. Adding an exchange rate component (when needed) to monetary targeting is now an accepted practice in Switzerland, while Norway’s use of SWFs to tame exchange rate fluctuations arising from energy exports has brought plaudits from macroeconomists everywhere.

Bob Mundell is right: the exchange rate has played a disruptive role as the most important price in the Canadian economy. However, we have it within our power to design policy approaches that will moderate exchange rate movements in ways that will enhance economic performance, foster intergenerational resource stewardship, contribute to interprovincial fiscal harmony and, above all, ensure that manufacturing and resource development can comfortably coexist within the Canadian currency area.